Contras: when your debtor is also your client's supplier

A contra exists when the same company appears on both of your client’s ledgers: as a customer on the sales ledger, and as a supplier on the purchase ledger. When that happens, the customer has a choice the financier doesn’t like. Rather than pay its invoice in full, it can deduct what your client owes it and pay the difference.

Why it matters to a financier

Suppose your client sells £40,000 of goods to Ashworth Packaging and buys £15,000 of materials from the same company. On the sales ledger, Ashworth owes £40,000, and you may have funded most of it. If Ashworth sets off the £15,000 it is owed, it pays £25,000. The £15,000 balance was never collectable, whatever the aged debtors report said.

The amount at risk is the smaller of the two balances. In this example that is £15,000, not £40,000. That is why the contra figure, not the debtor’s balance, is the number to take off what you lend against.

Many facility agreements exclude contra balances from the funds in use for exactly this reason. Exclusion only works if someone has found them.

Why they are missed

On paper, finding a contra means putting two lists side by side and looking for names on both. In practice, three things get in the way.

The names don’t match. The sales ledger says “Ashworth Packaging Ltd” and the purchase ledger says “Ashworth Pkg” or “Ashworth Packaging Limited”. A computer comparing exact names will miss it. A person scanning two long lists will often miss it too.

The supplier is only on part of the picture. Many auditors look closely at the top ten debtors and the top ten creditors. A company that is the fourth largest debtor and the thirtieth largest creditor appears in one list and not the other. The whole purchase ledger needs comparing, not just its largest names.

The relationship is new. A customer that started supplying your client last month won’t appear in last year’s audit. Contras need checking at every audit, not once.

The risk is the lesser of the two balances, not the debtor’s whole balance.

How to find them

Start from both ledgers in full, for the same date. Put every name into the same form: one case, no punctuation, and “Limited” and “Ltd” treated as the same. Then compare.

Keep the legal form in the comparison. “Ashworth Ltd” and “Ashworth LLP” are different companies, and treating them as one creates a contra that doesn’t exist. Anything looser than an exact match on the tidied name, such as a trading name or an abbreviation, is a suggestion for a person to confirm, not a match.

Then look beyond the ledgers. Bank statements may show payments to a company that isn’t on the purchase ledger at all: an invoice paid on arrival never appears as a balance. Group companies and common directors are worth a look too. A related company that buys from your client and is owed money by another part of the group creates the same risk with an extra step.

What to do when you find one

• Measure the lesser balance and take it out of what you lend against, as your facility allows.
• Ask the client whether the customer has ever set off, and whether there is any agreement allowing it.
• Look at past remittances from that customer. A payment that doesn’t match the invoices it covers can be a contra already taken.
• Ask the client’s credit controller to report any deduction taken on a remittance, rather than clearing it with a credit note. A contra written off quietly looks like ordinary dilution.
• Watch it at every audit. A contra relationship tends to grow, because the two companies trade more as it does.

Where contras are most likely

Some trades produce contras as a matter of course. Think of a manufacturer that buys packaging from a customer it also supplies, a builders’ merchant that both sells to and buys from local contractors, or a haulier that subcontracts loads to firms it also carries for. In each, the two-way trade is normal business, not a warning sign. It still reduces what is collectable.

When a new client is in one of these trades, ask about two-way trading before the first audit. The client usually knows which customers are also suppliers, and saying so early costs it nothing.

Merging names is often what reveals a contra

The most common reason a contra goes unseen is that the same company has been recorded twice under slightly different names. When the duplicates are merged, the two balances meet for the first time. So when a ledger is tidied up, look again for contras afterwards. A merge that joins two names can turn two small, unremarkable balances into one contra worth acting on.